Monday, December 31, 2012

I have grown tired of the moon, tired of its look of astonish-
ment, the blue ice of its gaze, its arrivals and departures, of
the way it gathers lovers and loners under its invisible wings,
failing to distinguish between them. I have grown tired of
so much that used to entrance me, tired of watching cloud
shadows pass over sunlit grass, of seeing swans glide back and
forth across the lake, of peering into the dark, hoping to find
an image of a self as yet unborn. Let plainness enter the eye,
plainness like the table on which nothing is set, like a table that
is not yet even a table.

At midnight tonight, as they do on December 31st every year, Buddhist temples around Japan will ring out the old year with 108 chimes of the temple bell, in a ceremony called Joya no Kane. Each chime is supposed to symbolize the purification of one of 108 sins, defilements, errors, and worldly desires that stand in the way of a believer’s passage to Nirvana.

I am no Buddhist, but I am a firm believer in the psychological and, dare I say it, spiritual benefit of ritual. No matter what ritual you follow tonight, may you cleanse the errors and confusions from your past life and replace them with the clarity of a clean and hopeful future.

It is time to say goodbye to the last, tired moon of 2012. Say hello to the sunrise of a brand new year.

Thursday, December 27, 2012

Yes, O Dearly Beloved, it is time. That season of the year has arrived in which Your Humble and Ever-Attentive Opinioneer attempts to survey which among his meager works has earned the attention, approbation, and/or opprobrium of the masses in Anno Domini Two Thousand and Twelve. My tools, as usual, consist simply of the page view rankings of posts authored this year as they have been recorded in Google Analytics. This data is necessarily incomplete and potentially unreliable, as it misses the actual eyeballs harvested by each respective post from the far greater numbers of people who simply visited the home page of this humble opinion emporium. But hey, it’s good enough for government work.

My feelings do not enter into this ranking, as I defer, as is my wont, to my Beloved Audience’s merest whim. Three hundred and sixty-four point two five days of the year, I convey my own opinions here. Today is your day.

Listed in order of popularity, as determined by you, here are this year’s greatest hits. Enjoy.

THE CANON, 2012 Edition

1) The Rules (November) — An excessively popular semi-tongue-in-cheek list of the rules for proper behavior in corporate finance and M&A. I will let you clever readers figure out which bits are tongue-in-cheek and which are only semi. No peeking.

2) Can’t Buy Me Love (April) — In which I explain why the great unwashed should not envy the reportedly stratospheric pay of investment bankers, nor should the eager young flock to my industry in search of endless wealth. I realize that few of the latter will listen, but perhaps I will save one or two as they come barreling through the rye.

3) Goodwill Hunting (November) — A prominent financial journalist uses the incident of Hewlett Packard’s writedown of its investment in Autonomy to embarrass himself publicly with the depth and breadth of his ignorance concerning firm valuation and the rules of public accounting. I, being of sound mind and generous heart, take mild exception and attempt to convey what are quaintly known in journalism as “the facts” to any and all individuals who might actually like to know them. Illustrated with one of Your Dedicated Bloggist’s favorite Frank Cotham cartoons.

4) The Root of Some Evil (January) — A respected academic named after a Harry Potter character attempts to tie senior financial executive pay to performance and, ultimately, link excess pay to the onset of the financial crisis. After engaging in deep breathing exercises and ingesting copious quantities of legal mood stabilization substances to reduce his skyrocketing blood pressure, your Tireless Servant and Guide to All Things Financial patiently explains why said academic is full of stinky goose shit. In summary, like most academics observing my industry from the outside, this scribbler would have been far better served actually learning how my industry works, rather than trotting out tired old shibboleths from the leafy groves of lazydeme.

5) The Rape of Persephone (January) — A rather lengthy disquisition on the practice of private equity investment, spurred by the extensive media attention triggered by the Presidential candidacy of a certain ex-Bain Capital poohbah, long since forgotten. I counter various pundits’ facile misrepresentations and misunderstandings of the financial sponsor business, and roast a few canards to boot. Short summary: private equity is not Evil Personified. It’s okay; I understand your shock.

6) All’s Fair (January) — Ex-investment banker William Cohan launches a scurrilous political attack against ex-private equity boss Mitt Romney. I respond by detailing the process of buying and selling companies and the nature of the negotiations involved. As you might suspect, the M&A arena is characterized by sharp elbows and sharp practices, pragmatically employed in the service of larger goals. Just like politics. Unsurprisingly, Mr. Cohan does not come off well.

7) Three’s a Crowd (March) — Wherein I use the very public J’accuse by Goldman Sachs apostate Greg Smith and a fellow traveler to delve into the structural and cultural workings of the investment banking industry. I describe the core conflict of interest or tension at the heart of my business and explain its origin as the ineluctable outgrowth of our attempts to serve the conflicting interests of different sets of clients. I also explain how the introduction of public shareholders permanently upset this tenuous balance for the worse. Yes, you heard me correctly: it’s the shareholders’ goddamn fault.

8) A Good Offense (April) — Was the famous beaching of J.P. Morgan’s “London Whale” an example of hedging gone awry or rank speculation undone? I examine the rotting carcass from several points of view and draw a few measured conclusions. Gratuitous World War II tank destroyer analogy included gratis.

9) Chesterton’s Fence (March) — Wherein I resurrect a hoary old chestnut from professional curmudgeon and Dead White Male G.K. Chesterton to remind us that professed reformers are wise to examine the history and reasoning behind objectionable human institutions before they decide to tear them down. While this was perhaps interpreted by most readers (and intended by Mr. Chesterton) as a defense against change, the rule offers a clearly defensible roadmap to reform: if upon examination we determine an institution was established for bad reasons, or reasons which no longer apply, then we are entirely justified in removing it or replacing it with something better. When the stakes are high, tradition should not survive simply because it is tradition. Neither should change happen simply for a change. Corollary: Do not look for simple answers at this site. I do not supply them.

10) Too Much Is Never Enough (October) — And, finally, a piece in which I explain the dirty little secret of the private equity industry: that, when they have incentives to overinvest or invest poorly—say, for example, when they risk losing money, prestige, and potential future earnings if they don’t invest the excess cash currently burning a hole in their industry’s pocket—these purported paragons of fiduciary probity can be just as self-serving as any venal schmoe. This conundrum neatly illustrates two general points worth remembering: 1) economic rationality or not, almost every human endeavor is riddled with conflicts of interest, and 2)

the primary mission of any institution, once it becomes large enough, is the perpetuation and survival of the institution itself.

The private equity industry, as an aside, has become very, very large.

* * *

Well, here’s hoping 2013 will be a marked improvement over 2012, in every dimension. This year has been a total bust.

Cheerio, children.1

1 Sorry, no clever footnotes this year. I’m fresh out. But hey, you get what you pay for, you know.

Thursday, November 29, 2012

Certain friends and acquaintances of mine have informed me on occasion of the existence of a website dedicated to codifying and promoting the rules of a secret society of bicyclists known as the Velominati. The Rules, as they describe them, are an interesting attempt to lay down a code of behavior for its members based upon honor, discipline, and a slightly suspect penchant for tight black riding shorts.

It occurred to me recently that a few of you among my regular readers might appreciate a similar codification of the rules of behavior for corporate finance and M&A investment bankers, minus the Spandex fetish.1 Accordingly, here they are. Use them wisely, and with moderation.

* * *

Rule #1 — Obey The Rules.
Duh.

Rule #2 — Lead by example.
It is forbidden for someone familiar with The Rules to knowingly breach The Rules or assist another person to breach them.

Rule #3 — Guide the uninitiated.
Investment banking is an apprenticeship business. Whether your charge is McKinley C. Higginbotham IV, scion of a long line of hoary investment bankers stretching back to the founding of Dillon Read at the dawn of the Pleistocene, or Mahindra P. Parametheswamenameran, fresh off the Tuesday boat from Mumbai with an I.Q. of 215, rest assured he or she knows absolutely jack shit about what to do with a client, a deal, or even a spreadsheet. Teach them, or consign your sorry, underleveraged ass to an early “retirement.”

Rule #4 — It’s all about the money.
It is absolutely, without question, unequivocally about the money. Anyone who says otherwise is a liar, a regulator, an MBA career counselor, or Matt Taibbi.2

Rule #6 — Free your mind, and your career will follow.
You are not paid to think. You are not that fucking smart. You are paid to do what the client wants you to do. Go do it. The time to add real insight, to offer careful, considered judgment, is before you get hired. Then, and only then, can you tell the client what you think they should do.3 After they hire you, they own your sorry ass. Apply your overwhelming intellect to how and when to achieve their objectives, not why.

Rule #7 — Dress like a professional, not like a clown.
Wear a suit. Buy good shoes. Own more than six ties. I don’t care what your clients wear, they expect you to look the part of a slick, overeducated, hyperaggressive, insanely successful mercenary. Bulletin: the clients who wear blue jeans and sneakers expect their bankers to be dressed to the nines, too, not like themselves, because they instinctively know the difference between an entrepreneur and a professional servant. You are a servant. Dress like one. Oh, and one thing more: no two-tone shirts, banker collars, suspenders, or bowties, unless you are God, a bajillionaire, or Felix Rohatyn. Or all of the above. Nobody wants to hire a fop.

Rule #8 — Investment banking travel is for badasses. Period.
Unless you are a management consultant or a senior petroleum engineer for a global integrated oil company,4 you have no idea what high stakes business travel really is. It’s getting up at 4:30 in the morning to catch a flight across three time zones to meet with some asshole client who’d as soon as piss on you as take a meeting. It’s getting a call at your Milan hotel in the middle of a weeklong business trip to catch the next flight to Beijing for a two hour meeting with a bunch of government officials you’ve never even met. It’s traveling to some of the most famous and exotic destinations on the planet, only to have them all look the same: airport—>taxi—>hotel room—>taxi—>conference room—> taxi—>airport. It’s learning to become a connoisseur of hotel room service, a Jedi Master of airport Starbucks. Forget about private planes. Those are for clients and the senior executives at the top of your firm. Forget about first class. The only time you’ll get to the front of the plane is when you pay for it with your own money or the umpty billion upgrades you’ve earned by traveling to Hell and back a bajillion times this month alone. So travel like you mean it. Don’t fuck around: Rollerboards are for pussies. Checking luggage is for young families on vacation and old ladies. Neck pillows are for moral degenerates. When in doubt, see Rule #5.

Rule #9 — It never gets easier, you just make more money.
Investment banking is hard. It stays hard. The more success you have, the higher your clients’, managers’, and shareholders’ expectations rise. You’re only as good as your last trade or your last deal. Last year was last year, asshole: what have you done for me lately? Furthermore, the higher you rise in the pyramid, the closer you come to the clients, managers, and shareholders and their unrelenting, unreasonable, unjustifiable demands. Sur la Plaque, fucktards. See Rule #5.

Rule #10 — Don’t be a scumbag.
The pressure, the money, and the prestige will tempt you to cut corners. To steal credit. To stab colleagues and subordinates in the back. To gutlessly steamroll brighteyed young acolytes in the name of shareholder returns or your own personal compensation. Resist this. Don’t be a fucktard. Don’t be a gutless pussy. The life of an investment banker is nasty, brutish, and short. But if you can manage to avoid succumbing to the myriad base temptations to screw people over the profession offers you, you will earn a reputation as a... as a...

Oh, screw it. You won’t earn any reputation at all, except maybe among a few hundred of your professional colleagues. The general public won’t ever know or care about you at all.

But since when did you care what the general public thinks? Matt Taibbi sure doesn’t think you do.

1 There are only two rules for my colleagues on the other side of the house, in Sales and Trading: 1) Don’t get caught; and 2) Don’t eat more than two onion cheeseburgers before 8:30 am every morning.2 Regardless of what Matt Taibbi says, of course, it’s not all about the money. But let’s level set, shall we? Matt Taibbi’s not as stupid as he sounds.3 If you have the balls. And senior management’s support.4 And if you are, why the fuck do you travel like me while getting paid a fraction of what I do? You’re smarter than that.

Thursday, November 22, 2012

When in disgrace with fortune and men’s eyes
I all alone beweep my outcast state,
And trouble deaf heaven with my bootless cries,
And look upon myself, and curse my fate,
Wishing me like to one more rich in hope,
Featur’d like him, like him with friends possess’d,
Desiring this man’s art, and that man’s scope,
With what I most enjoy contented least;
Yet in these thoughts my self almost despising,
Haply I think on thee,—and then my state,
Like to the lark at break of day arising
From sullen earth, sings hymns at heaven’s gate;

For thy sweet love remember’d such wealth brings
That then I scorn to change my state with kings.

Wednesday, November 21, 2012

I make every effort to exercise regularly, eat healthy food, and maintain my legendary composure by adhering to a strict drug and alcohol regimen sketched out on a bar napkin in 1962 by Hunter S. Thompson himself. But every so often, some ill-advised knucklehead will publish, under the aegis of a purportedly respected publication, such toxic, ridiculous, and misleading nonsense that I simply must respond with decisive and overwhelming force.

Today’s example hails from the eponymous financial newssite of Gotham City’s favorite sesquibillionaire mayor and short-man-about-town, Mike Bloomberg. In it, the award-winning [sic] financial journalist Jonathan Weil ventures the following thesis for the entertainment and edification of his hapless readers:

Here’s the problem with Hewlett-Packard Co.’s explanation today for why it took an $8.8 billion writedown related to its purchase of Autonomy Corp.: The numbers don’t make sense.

He then spends the next nine paragraphs making sure the numbers don’t make any sense and befuddling the naive and inexperienced among his audience into a state of utter confusion matched only by his own apparent cluelessness. Chief among his complaints seems to be that he doesn’t understand how HP can write down over $5 billion of value due to allegedly dodgy accounting associated with Autonomy when the latter had pre-acquisition assets totalling only $3.5 billion. He also seems very suspicious of the $6.6 (later $6.9) billion of goodwill Hewlett-Packard recorded when it purchased Autonomy, writing that

HP recorded the goodwill because it knew Autonomy’s identifiable assets were worth much less than it paid.

The implication being, of course, that HP actually knew it was “overpaying” for Autonomy at the time and that the current writedown is really just HP acknowledging the inevitable.

Call me crazy, but I have to believe there are some among you who might agree with me that it seems reasonable a journalist tasked with covering financial markets, stocks, and corporate finance should have at least some basic understanding of public accounting rules and merger math. Or at least the time, resources, and ambition to find out. Apparently we would be wrong.

So, in the interest of trying to rescue some of the well-meaning ignoramuses who have been happily educated into insensibility by Mr. Weil’s folly, I will try to provide a mini-primer on purchase accounting. In the course of this, I believe I can demonstrate that, indeed, Hewlett-Packard’s recent accounting writedowns make perfect sense.

* * *

Chief among the conceptual foundations of merger math which we must address is the distinction between enterprise value and book value, or true value and accounting. Most mergers and acquisitions are done to acquire operating businesses, not merely a laundry list of assets. Just like the real value of Apple Computer cannot be reduced to its Cupertino real estate, the inventory in its factories and stores, and the office supplies in its employees’ desks, the real value of an operating business lies in the way its management and employees use those assets, their knowledge, and their company’s brand and reputation to earn income. That is what a business acquirer will pay for.

How much an acquirer will pay for a business is determined in the course of merger negotiations by reference to comparable companies trading in the public markets, comparable M&A transactions, and the projected discounted future cash flows of the target business, overlaid by the competitive dynamic of the sale process. At the end of the day, the acquirer pays what it decides owning the target business and its associated cash flows would be worth to it, moderated by what it has to and can afford to pay. The book value of assets on the target company’s balance sheet has nothing to do with it.

Once the ink has dried on the purchase agreement and the checks have cleared, however, the accountants move in to memorialize (or embalm) the transaction in their own special way. They review the balance sheet assets and liabilities of the target company to determine their fair market value at the time, which more often than not is different from their recorded book values.1 Tangible assets like receivables, inventory, real estate, fixtures, and office supplies are valued at replacement cost or nearest appropriate market value and recorded in the opening balance sheet. Then the gnomes attempt to quantify the value of discrete and identifiable intangible assets like patents, customer lists, brands, and other intellectual property: all the assets you cannot put your finger on but you know are essential to generating the ongoing revenues and cash flows of the business. Add these together, and you have all the tangible and intangible assets which can show up on a balance sheet. Subtract that total (less the fair value of operating liabilities like accounts payable) from the amount of money you paid for the business and, presto, you get goodwill: the accountants’ remainder account where they memorialize the premium to the target’s net tangible and intangible assets the acquirer paid for the business. Goodwill can be seen as the difference between the full operating value of a business—as paid at one point in time by a third party buyer in a specific arms length transaction—and the fair value of the net operating assets its managers and employees use to run it.

So when Hewlett-Packard decided to write down the value of its investment in Autonomy, it did not inventory paper clips. It revalued the remaining intangible assets on its balance sheet acquired from Autonomy, based on their newly-determined earning power, and it revalued the goodwill of the total business based on its revised understanding of its overall cash generating capability. If Autonomy did indeed misrepresent the earning power of its business as HP alleges, goodwill would be the exact account where you would expect to see writedowns.

Autonomy misrepresented its gross profit margin and also falsely created or miscategorized more than $200 million in revenue over a two-year period starting in 2009, John Schultz, Hewlett-Packard’s general counsel, said in an interview. Autonomy was reselling Dell Inc. computers and counting those sales as software revenue, he said. Some sales were also fabricated through resellers.

When your view of the value of a business or collection of assets changes, accounting rules compel you to revise any associated goodwill account to reflect this new information. This is not that difficult a concept to grasp or convey.2

I just wish our financial press corps was better at educating the public about such things, rather than muddying the water because they’re too lazy to figure it out beforehand.

* * *

UPDATE November 21, 2012: Ugh. Apparently Jonathan Weil has not heard of the Law of Holes:

When you find yourself in a hole with a shovel in your hand, stop digging.

He has released another post today in which he throws about random balance sheet, income statement, and market value numbers from Hewlett-Packard’s accounts without the least apparent understanding of what any of them mean or their most basic interrelationships. He is trying to make the argument that HP massively overpaid for Autonomy in the first place, and that the admittedly skimpy numbers which the former has released in connection with its writedown announcement do not seem to disprove his thesis. He may be right, for all I know. I do not know and I do not care.

But when he spews forth idiotic, misleading dreck like this, my ears begin to smoke:

HP finished the fiscal third quarter with $32 billion of shareholder equity. Its balance sheet showed $36.8 billion of goodwill (which isn’t a saleable asset) and $8 billion of other intangible assets. By comparison, HP finished the fiscal fourth quarter on Oct. 31 with a stock-market value of $27.2 billion.

In other words, on paper, HP’s goodwill supposedly was worth more than the company as a whole [emphasis mine]. The market knew big writedowns were necessary. Investors saw that Autonomy was a disaster. They were just quicker to acknowledge the reality than HP was.

No, no, no, no, NO. No, you numbnuts. Goodwill is a balance sheet account, based on historic book value with periodic testing to check that it is still valid. It bears no direct relation to what the company is worth at all.

And the worth of the company is not equal to the market value of its common equity, except in the most trivial of cases. The company’s worth, or value—known among people who actually work with this concept for a living, like me and, oh, a billion other non-idiots as total enterprise value—consists of the market value of common equity plus the market (or book) value of debt and other capital liabilities less cash on hand. In HP’s case, at the end of its 2012 fiscal third quarter, this was $27.2 billion + $29.7 billion – $9.5 billion, or $47.4 billion. At July 31, 2012, Hewlett-Packard as a whole was worth $47.4 billion. This, just to help Mr. Weil in case he runs out of fingers, is clearly more than $36.8 billion in goodwill. Which, by the way, doesn’t mean anything, just in case you were wondering.

You might argue that with my carping I am overreacting to Mr. Weil’s sloppy writing and thinking and missing his larger, potentially valid point about the poor rationale for HP’s purchase of Autonomy. But I am traditional enough to believe that a person who puts himself out there as a financial journalist who writes about M&A and corporate accounting issues for an international financial publication should fucking know a little about goddamn basic accounting.

And someone, please, buy Jonathan Weil a basic accounting textbook and make him read it before he writes again. My blood pressure will thank you.

1 Goodwill already on the target company’s balance sheet from prior acquisitions of its own, like the $1.5 billion in Autonomy’s pre-deal accounts, is written off at once. Of the remaining $1.9 billion of Autonomy’s pre-deal assets, over $700 million was cash and $600 million was other intangibles. Hewlett-Packard acquired very few tangible operating assets of any kind when it bought Autonomy.2 I don’t have an opinion, by the way, as to whether HP’s allegation of accounting shenanigans is true or not. Autonomy’s former management disputes it. All I will say is valuation of intangible assets either in a sale transaction or on an interim basis and valuation of the long-term earnings power of a business where there is no concrete, objective reference point like a deal value to point to can be awfully squishy, subjective stuff. This, naturally, raises the question as to whether HP might be sandbagging its goodwill writedown to make future results look better. I have no special insight here, other than to note such an occurrence has happened many times before.

Monday, November 5, 2012

Not only is it rational, under certain circumstances it can be morally virtuous.

And, notwithstanding the preceding perspectives, it is a civic duty1 which is entirely reasonable and rational for the democratic society to which you putatively belong to expect you to perform. It is a voluntary, non-monetary tax, if you will, a donation of your time and inconvenience toward the common good from which you and the rest of your fellow citizens daily benefit.

Finally, regardless of your political or ideological affiliation, you must appreciate that the more people like you vote, the less likely our polity will be hijacked by the whackos, the unhinged, and the mentally and morally bankrupt members of the opposition.

Unless, of course, you are a member of said whackos, unhinged, etc. In which case I suggest you vote Thursday.

Happy Citizenship Day!

1 I am well aware, O Dearest and Most Indulgent of Readers, that duty is an unpopular word (and concept) in our current culture and society. I remain unapologetic in its use, and consider its unpopularity to be a stain upon the society which undervalues it, rather than a valid critique of the concept itself. Call me anachronistic if you will. I’ve been called worse.

What are you looking for, when you walk into a corner and stand, unseeing, with your nose pointed to the wall? What drives you to squeeze behind tables and chairs, to hide under sofas and beds where nothing and no-one can disturb your privacy but the slow drifting down of dust?

What makes you stop and stare across the street, at nothing at all? What makes you turn and walk slowly toward that emptiness, as if to some summons only you can hear?

I know it is nothing you see, or smell, or hear. You are like a plant, turning blindly toward the heat of a sun you feel but cannot see. The call is patient, beckoning.

What goes through your head at these moments? You must be waiting; waiting for the moment when that invisible door finally cracks open, flooding you with light and beckoning you to your long home. You must pass through that door alone, as we all must.

I will miss you when you go.

I cannot follow you now, Old Friend, not now. But I hope to see you again soon.

Sunday, October 21, 2012

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else — if you ran very fast for a long time, as we’ve been doing.”

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place.

If you want to get somewhere else, you must run at least twice as fast as that!”

— Lewis Carroll, Through the Looking Glass

I admire Gillian Tett, I really do. She is a fine, perceptive, and aggressive financial reporter and writer who has contributed a great deal to our understanding of the origins of the recent financial crisis, as well as many other things.

Reading between the lines, Ms Tett recently returned from a clutch of cocktail parties and dinners with American friends whose children were admitted to elite U.S. universities this Fall. From her remarks she seems to have heard the sort of alternately smug, self-serving, paranoid, and neurotic bullshit and misinformation that I have been subjected to for the past several years as the parent of a high schooler recently off to college and one in the chute. In my experience, middle and upper class parents with children of college-bound age in Manhattan and other socioeconomic pressure cookers are the worst sort of frantic, hypercompetitive cynics you can encounter, and they will grasp at the flimsiest and most ridiculous of straws to support their desperate hope little Susy or Billy will get into a top university.

Hence you get nonsense—unsupported in Ms Tett’s piece by any citation or reference (and no doubt made up by some bug-eyed X-ray socialite over Cosmopolitans in a Park Avenue co-op)— that “educational researchers estimate that... having a family link [to the school she is applying to] increases a mid-level student’s chance of entry by about 60 per cent.” Since when? Says who? And how the fuck did they figure out that differential admission statistic? Did they sneak into the Harvard Admissions Office after hours and steal the ULTRA-TOP-SECRET-ON-PAIN-OF-DEATH-NEVER-SHOW-TO-PARENTS-REAL-ADMISSION-CRITERIA folder?

It is just that sort of made-up, silly statistic or “secret” to guaranteeing Bif or Muffy a spot at Yale that I have had thrown at me for the last several years by people convinced of its veracity. The same sort of secret that charlatans use to dupe desperate parents into paying tens of thousands of dollars for “college admissions consulting” services. Let me give you the real scoop: all those secrets are bullshit. How do I know? Easy: nobody has the data to figure it out.

* * *

Annnyhoo. Enough of my ranting.

Of the Holy Trinity of Higher Education in North America—Harvard, Yale, and Princeton, known succinctly as HYP—only Yale is indiscreet enough to make the percentage of its enrolled freshmen from the Class of 2016 who are legacies easy to find: 13%. This aligns neatly with the 15% estimate from the unidentified “educational researchers” Ms Tett cites. One would be surprised if Harvard, Princeton, and other pretenders to the triple throne like Stanford were much different.

But let’s examine just how damning this statistic really is. One measure is that Yale also reveals that 12.1% of its current freshman class are first-generation college students; that is, students who are the first members of their family ever to attend a four-year college or university. You can’t find an antidote to the perpetuation of entrenched elite privilege more effective than this: the sons and daughters of high school graduates (or worse) comprise almost as large a percentage of the anointed New Haven elite as do the scions of Elis past. There’s nothing like an uneducated janitor’s daughter with perfect SAT scores and a 4.0 GPA to rattle the security and worldview of Winthrop P. Witherspoon IV.

A second reassurance can be drawn from the academic records of the students these institutions admit. Ninety-five percent of Yale’s enrolled freshmen were ranked in the top 10% of their high school class; 96% of Princeton’s were. If the Ivy League is admitting the idiot sons and daughters of alumni in preference to striving young geniuses from the wrong side of the tracks, they sure are some smart idiots. Similar conclusions can be drawn from the admission statistics based on board scores and GPAs. In comparison to its overall admit rate of 7.9% last year (2,094 admits out of 26,664 applicants), for example, Princeton offered a spot in its pantheon of privilege to only 10.4% of students who applied with a perfect grade point average and 18.7% of applicants with SAT scores 2300 and higher (out of 2400). On an overall basis, Harvard and Yale were even stingier with their golden tickets: only 5.9% and 6.8%, respectively. Let’s face it: no matter what your qualifications are, your chance of getting into one of these three schools is vanishingly small.

* * *

Ultimately, you must understand that the most elite institutions of higher learning in this country are looking to build and cultivate student bodies that are vibrant and diverse in almost every dimension: background, ethnicity, geography, interests, and extracurricular talents. They do this because they want to—diversity attracts the best students and polishes their institutional reputation—and because they can. Students from all over the world submit almost 90,000 applications for admission to less than 4,400 slots at HYP alone. In this dynamic, superb intellectual and academic ability is simply table stakes. If you don’t have it, you probably won’t even make it past the first round.

We estimate that over three quarters of the students who apply for admission to Yale are qualified to do the work here. Between two and three hundred students in any year are so strong academically that their admission is scarcely ever in doubt. But here is the thing to know: the great majority of students who are admitted stand out from the rest because a lot of little things, when added up, tip the scale in their favor. So what matters most in your application? Ultimately, everything matters.

Including whether you are a legacy. Perhaps, if you are competing against an otherwise indistinguishable applicant, one with intellectual abilities, ethnicity, and extracurricular interests identical to your own, being a legacy will tip the scale in your favor. But, more often than not, you will likely be competing for a slot with someone who has another set of qualities seductive to the university. Princeton discloses the admissions criteria it uses to the federal government: “Very important” = academic capability, talent, and character; “important” = extracurriculars; “considered” = legacy, first generation student, geography, race/ethnicity, volunteerism, and work experience. Being the child of an alumnus or alumna is in no way a lock.

It is also worth noting that the children of privilege, the elites we are so worried about perpetuating via access to our most hallowed educational institutions, often come from the least “diverse” and hence least attractive racial and ethnic groups to these leading universities. Ceteris paribus, how much does ticking the legacy box weigh against the diversity agenda?

* * *

I have witnessed up close and personal the rank cynicism which Ms Tett has imbibed from her friends. A substantial number of the Manhattan parents I socialize with repeat with absolute conviction the belief that a huge donation is the price of guaranteed admission for their child to an Ivy League school. Stories circulate on the Upper East Side whisper circuit of a $5 million check to one school, a $10 million one to another. Unspoken is whether the children in question were talented and interesting enough to get in on their own merits. For some reason, this seems to be considered beside the point, which is immensely sad in its own right.1

In some respects, the leading universities’ refusal to be more transparent about their admissions process perpetuates this belief. A cynic might say they prefer it this way. After all, a parent desirous of sending Junior to Harvard cannot change her status as an alumna, but she certainly can change the frequency and amount of money she donates to her alma mater. The trick is there is no explicit quid pro quo. I know several alumni who donated generously to their university only to see their children rejected.

But frankly, the connection between legacy admissions and donations is spurious. Very few alumni can write the sort of check that would retrieve their son or daughter from the reject pile at HYP. Most alumni simply don’t have that much money. Many of them are successful, true, but not all of them are, and very few qualify as truly rich. And the truly rich can write a check to Harvard, Princeton, or Yale for their kid whether they went there or not.

The real issue which Ms Tett does not address—the real way elites perpetuate themselves—is they do whatever they have to to make sure their children are prepared to compete head to head with other children on the primary criteria for college admission. They send their kids to expensive private schools, they hire tutors to buff their performance in school and on standardized tests, and they work their extensive social networks to get internships, enriching extracurricular experiences, and letters of recommendation to bolster their resumés, transcripts, and college applications. This is the true advantage educated elites have in the college admissions game: it’s not so much that they game the system—the system is less gameable than people think—but they spend whatever it takes to win according to the existing rules.

Is this fair? I don’t know. But I will say this: it is far more likely that the children of the elite compete more with each other than they do with applicants from other diversity buckets (ethnic, geographic, extracurricular). In this way, the developmental arms race among elite parents ends up looking more like a sociological version of the Red Queen Effect than it does unfair competition against the weak and underprivileged.

Harvard, Princeton, and Yale can take care of the latter. Nobody helps the elite but ourselves.2

“Do you mean, sir, that these birds are cannibals?”

“That’s an odd question, young Master,” the banker said. “I merely said the birds drink blood. It doesn’t have to be the blood of their own kind, does it?”

“It was not an odd question,” Paul said, and Jessica noted the brittle riposte quality of her training exposed in his voice. “Most educated people know that the worst potential competition for any young organism can come from its own kind.” He deliberately forked a bite of food from his companion’s plate, ate it. “They are eating from the same bowl. They have the same basic requirements.”

1 Not frequently enough discussed in this whole topic is the emotional and psychological cost to our children of such shenanigans. First, the debilitating suspicion that, without Mommy and Daddy’s money, influence, and machinations, the child herself could not accomplish what her parents so desperately expect of her. Second, the loss of childhood freedom, lack of care, and play to relentless careerism and resumé polishing. In my position as a father of teenagers and an interviewer of recent college graduates, I see far too many astonishingly accomplished young people who never seem to have had a childhood.2 This is not a complaint. Simply an observation.

Saturday, October 20, 2012

New York, New York
A wonderful town
The Bronx is up, and the Battery’s down
The people ride in a hole in the ground
New York, New York!
It’s a wonderful town!

...

Manhattan women are all in silk and satin,
So the fellas say
There’s just one thing necessary in Manhattan,
When you’ve got just one day:
Gotta pick up a date
Maybe seven or eight on your way
In just one day!

Hey, girls, get ready! It’s Fleet Week, and the drunken sailors are spending money like there’s no tomorrow. You’d have to be a stony-hearted harridan not to offer them a little fun and companionship, right? Especially since they’re buying.

* * *

Articles are beginning to appear in The Wall Street Journal and elsewhere documenting the return of the slightly disreputable and mildly creepy uncle of the financing world, the dividend recapitalization, or recap. I can already hear the sucking of teeth and clucking of tongues among disapproving maiden aunts in the mainstream media and blogosphere.

Debt issued to fund private-equity dividends has topped $54 billion this year, after a flurry of deals earlier this month, according to Standard & Poor’s Capital IQ LCD data service. That is already higher than the record $40.5 billion reached in all of 2010, when credit markets reopened after the crisis.

For private-equity investors, the deals produce payouts amid a slow market for initial public offerings and acquisitions. “It’s hard to be anything but happy” about the dividend boom, said Erik Hirsch, chief investment officer for Hamilton Lane, a Philadelphia firm that manages more than $163 billion in private-equity investments.

Likewise, many debt investors are happy to collect yields as high as 10%.

Critics say the dividends, which are disclosed in offering documents, saddle a company with debt, potentially burdening its operations, while reducing a private-equity firm’s investment exposure.

Also some of these deals involve a risky type of debt known as “payment in kind toggle”—or PIK-toggle—bonds that give companies the choice to defer interest payments to investors. Instead, they could opt to add more debt to the balance sheet. The default rate for companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the default rate for comparably rated companies that didn’t use the bonds, according to a study by Moody’s Investors Service.

Six companies have sold PIK-toggle bonds to pay private-equity dividends in September and October, double the number sold in the previous 14 months.

Our Lady of Perpetual Fiscal Rectitude is surely spinning in her grave at these revelations.

* * *

But just as there are creepy uncles and creepy uncles, there are dividend recaps and dividend recaps. The PIK toggle example the article cites—Hellman & Friedman’s $525 million issue to fund a $600 million dividend for a recently purchased drug developer—looks pretty anodyne upon closer inspection. H&F bought the company last December, when lending markets were stressed, using approximately 50% equity and 50% debt.1 Raising debt to dividend out $600 million leaves the company with approximately $1.35 billion of equity supporting an enterprise valuation and capital structure of $3.9 billion. At 35% equity-to-total capital, the resulting leverage ratio is pretty standard for a leveraged buyout and, pace any specific unusual risks in the company’s business model or operating prospects, should provide a pretty safe and secure capital cushion for the creditors.

This is no wild-eyed sailor barebacking his way through the alleys of Bangkok. Hellman & Friedman overequitized the purchase at closing because it had to (and because it could; that is, it had an extra $600 million lying around), and it simply came back to market under currently more attractive conditions to fine tune its portfolio company’s capital structure. It was the prudent, responsible, and appropriately fiduciary thing to do. Plus, the new PIK holders get a nominal yield of 9 7/8% on a fresh buyout undergirded by $1.3 billion of equity from a respectable financial sponsor. What’s not to like about that in an environment where fixed income investors are lucky to find yields in excess of 3%? Those pensioners’ medical bills won’t pay themselves, you know.

The same cannot be said, however, for the debt Leonard Green and CVC Partners raised to pay a $643 million dividend to themselves (i.e., to their funds and hence their limited partner investors) for the buyout of BJ’s Wholesale Club last year. According to the article, this debt repaid the entire initial equity investment the sponsors made to purchase the company in the first place, which means, essentially, that they and their fund investors are now playing with house money. Depending how much equity Leonard Green and CVC shared with current management and other co-investors, their funds now control something like 75 to 85% of the equity of a $2.8 billion corporation at a net cost of zero dollars. Pretty sweet, huh? I’d like a few of those deals myself.

What this skeleton outline does not reveal, however, is data which might explain why new debt investors decided to lend so much money in the first place. I have explained in the past that creditors principally base their decision to lend to a corporate borrower on what they calculate it can afford to pay, appropriately adjusted for risk, uncertainty, and the unexpected collapse of Americans’ compulsive desire to buy 50 gallon drums of olive oil for $19.95 apiece. There may be very strong operating cash flow support for the new and existing debt of BJ’s, I don’t know. But if I were an investor in the debt funds or a pensioner in the pension funds which bought these bonds, I would be very curious to find out.

The reassuring thing to consider in this scenario, from the lenders’ point of view and that of kibitzing journalists, is that the financial sponsors, while certainly facing a reduced risk profile, have not abandoned all incentive to make the buyout work by taking their initial stake off the table. Consider: returning your LPs’ entire initial investment after one year may be comforting, but it represents a return on capital of exactly zero percent (less if you adjust for the risk of tying it up for a year). No private equity firm can survive if it makes that its core business model. No, financial sponsors operate on an investment model that generally targets total returns of 2.5 to 3 times their investors’ money (more if they can get it, of course) over the course of 3 to 5 years. If they deliver that, they make their limited partners very happy and themselves very rich. Leonard Green and CVC have every incentive to work with management to make BJ’s a huge success, and BJ’s creditors know this. In part, they are relying on it.2,3

* * *

When they are not simply delayed borrowings designed to adjust the capital structure of an LBO to its original intended optimal state, like the H&F deal, dividend recaps are risk adjustment tools for private equity firms. They convert the risk profile of the investment from a pure equity-like one—where you participate one-for-one in the increase of value of the firm but can lose your entire investment if the company goes bust—to one that looks much more like an option: limited (or zero) downside below the threshold of the amount borrowed and one-for-one participation in the upside.4 If you can buy yourself and your investors such an option for a reasonable price (i.e., interest rate), why wouldn’t you?

And that is the point, and one of the key reasons financial sponsors are beating a path to the doors of high yield investors nowadays. Lenders are selling these options cheap because their investment alternatives suck. Furthermore, unlike the prelapsarian glory years of 2006 and 2007, high yield investors have fewer opportunities to invest as part of the initial capital structure of leveraged buyouts and other acquisitions now because M&A volumes are way down. Deals aren’t getting done, so lenders have to lend to the people who are asking for money. On the flip side, financial sponsors are coming to lenders for dividend recaps hat in hand because there is so little M&A activity they cannot sell their portfolio companies for love or money. Financial sponsors are increasingly trapped in aging investments they can’t sell to strategic corporate buyers, because corporate boards and CEOs are still hiding in their executive washrooms sucking their thumbs in paralysis over global economic uncertainty. And they can’t sell their companies to public equity market investors via IPO unless they can persuade somebody their widget manufacturer is really a social media powerhouse.

So, tongue clucking and tut-tut-ing aside, dividend recaps are surging because they’re the only game in town. The girls are horny, and the Navy is in town. Deal with it, Aunt Betsy.

1 The article does not disclose whether H&F was able to assume existing company debt “on the balance sheet” or had to raise it afresh. It doesn’t matter for the purposes of our discussion.2 More to the point, they are relying on their own due diligence that the company itself can support the entire debt load placed on it in a way that gets their loans repaid timely and in full. From a creditor’s perspective, it is reassuring to know someone lies beneath you in the capital structure to cushion your fall if the wheels come off the bus, but you’re much more concerned to get comfortable that the chance of said wheels leaving said bus is very slight in the first place.3 The wicked person in me wants the BJ’s deal to fall apart, because it would create an entire sub-industry of off-color joke telling in my business. “Did you hear about the BJ’s deal? It sucked!”4 In effect, you buy a put option from the lenders for residual liquidation values of equity below the amount borrowed. The option premium is simply the cost of borrowing. The payoff looks like a call option, or, what is the same thing, a long equity + put option combination.

Tuesday, October 9, 2012

He walked along the road feeling the ache from the pull of the heavy pack. The road climbed steadily. It was hard work walking up-hill. His muscles ached and the day was hot, but Nick felt happy. He felt he had left everything behind, the need for thinking, the need to write, other needs. It was all back of him.

— Ernest Hemingway, “Big Two-Hearted River: Part I”

There is a palpable indifference to natural landscapes in the West; an indifference to human scale and concern which the sensitive traveler can feel. You get the sense that the landscape is so large, so wrapped up in its own immensity that the quotidian concerns of the humans crawling over its surface are as important in its calculus as those of ants are to us; that is, not at all. Not that there is actual hostility, mind you, just complete and utter indifference. It is as if the last 50,000 years of human history had been erased, or yet to happen, and the mountains and the rivers and the sky just couldn’t care less.

The feeling of landscape in the Eastern United States is different. While the Appalachians, geologists tell us, were once as tall and imperious as the Alps or the Himalayas, millions of years of wind and rain and little animals digging in the dirt have rounded and smoothed and ground them down to a softer aspect, a more human scale and image. Towering alpine peaks have collapsed in slow motion over eons into deep alpine valleys, and the soft, rolling landscape we see now is the faded shadow of its former glory. If the Rocky Mountains and the Sierra Nevada are the brash young men of the North American tectonic plate, sharp, thrusting, and cold, the Appalachians are the comfortable old grandmother stroking her frightened grandchildren in the thunderstorm.

I love the beauty of both environments, but in different ways and for different reasons. The forests and valleys of the East invite me to enter in and explore, to commune with nature as an integral part, a hunter or a hiker or an explorer who searches for creatures and features of the landscape close at hand, of my scale, and easy to grasp. In contrast, the Western wilderness compels distance and contemplation, very much like the state of mind I enter when I gaze upon the cold, indifferent stars so far above the quiet nighttime landscape.

The landscapes of the East remind me of my love for life. The landscapes of the West—like the endless vista of the stars above—remind me how small, insignificant, and precious it ultimately is.

Saturday, October 6, 2012

This is what civilizations and societies always do: remake the past in the present’s image, mistake the current conditions of knowledge and experience and feeling for an unchanging human condition or biological reality.

Camille Paglia has a very odd, rambling piece in The Wall Street Journal today, talking about capitalism and the visual arts. I am unfamiliar with Ms Paglia’s oeuvre, so I cannot say whether the style of this article is of a piece with the rest, but if it is, I am unimpressed. It reads like a disjointed tour d’horizon, pointing out features of the landscape, interspersed with unsupported and grandiose claims, that never comes to a recognizable conclusion: “Here is a thing, and here is a thing, and this is a fact. Ergo, QED.” Huh?

Her basic thesis seems to be that the visual arts are stuck in the doldrums:

Performance genres like opera, theater, music and dance are thriving all over the world, but the visual arts have been in slow decline for nearly 40 years. No major figure of profound influence has emerged in painting or sculpture since the waning of Pop Art and the birth of Minimalism in the early 1970s.

Well, okay, one might quibble whether leading contemporary artists like Damian Hirst, Jeff Koons, and Takashi Murakami are good artists, or artists who will leave a lasting historical impression on the visual arts, but only a fool (or a cultural critic seriously ignorant of the contemporary art scene) would deny they have indeed been highly influential.

She goes on:

What has sapped artistic creativity and innovation in the arts? Two major causes can be identified, one relating to an expansion of form and the other to a contraction of ideology.

Painting was the prestige genre in the fine arts from the Renaissance on. But painting was dethroned by the brash multimedia revolution of the 1960s and ’70s. Permanence faded as a goal of art-making.

This is just dumb.

First of all, the dethronement of painting as the prestige visual art—which, by the way, has been a very long time coming, and started far earlier than the 1960s—and the rise of multiple competing media spurred innovation, and unleashed a vast influx of energy and creativity into the field which it otherwise would not have enjoyed. In addition to opening up new aesthetic dimensions to explore and exploit that painting with pigment on a two dimensional surface could not, contemporary arts like video and photography and new industrial techniques for sculpture and printmaking attracted vast new numbers of artists into the field who would otherwise have lacked the talent or interest to make meaningful art in traditional media. (Not everybody can paint.) The fact that ways of creating visual art exploded vastly expanded creativity and innovation, not sapped it. This is just plain common sense, in addition to historical fact.

Second, Ms Paglia’s unsupported assertion that permanence faded as a goal of art just isn’t true. Sure, visual artists have been exploring the aesthetic dimensions and implications of impermanence for some time now, all the way back to Ms Paglia’s self-professed “hero” Andy Warhol and his “happenings” in the 1960s, if not before. But for every shark carcass rotting in a tank of formaldehyde or public sculpture carved out of flowers, contemporary artists have given us plenty of paintings, sculptures, and objects which are designed, if only by virtue of being composed of plastic and metal more durable than any organic pigment, to last much longer than your local museum’s Da Vinci. Lastly, just in case Ms Paglia hadn’t noticed it herself, impermanence has become a permanent psychological, sociological, and economic feature of contemporary society. Does she think visual artists as a class are so insensate to this fact or so reactionary that they would not find exploring the condition of impermanence to be an interesting and important theme for their art? And what better way—as only one of many solutions—to do so than to make the work of art itself impermanent? After all, let art collectors and museum curators worry about how to preserve your decaying ice cream sculpture of Henry Ford: that’s conservation, not art.

Hang on. She’s not done yet:

But there is a larger question: What do contemporary artists have to say, and to whom are they saying it? Unfortunately, too many artists have lost touch with the general audience and have retreated to an airless echo chamber. The art world, like humanities faculties, suffers from a monolithic political orthodoxy—an upper-middle-class liberalism far from the fiery antiestablishment leftism of the 1960s.

And what is missing from this airless ideological echo chamber, according to our narratrix? Why religion and capitalism, of course. (This is an opinion piece in The Wall Street Journal, after all.) 1

But this is just loony too.

* * *

Put aside, for a moment, the fact that contemporary art has made the nature of modern societies, including capitalist ones,2 a central theme and topic. To be sure, most artists’ treatment of contemporary socioeconomic mores has been critical rather than laudatory, and it is reasonable to expect the political monoculture Ms Paglia postulates in the art world (and which I have no particular reason to doubt) might have something to do with this. Put aside the facile conflation of art world and academy which Ms Paglia uses to bolster her ideological point, a conflation which ignores substantial areas of difference between the two and the irrefutable fact that many (most?) successful practicing artists never went to college. And put aside the fact that ongoing recession in the economy and the recent global financial crisis has soured the opinion many members of society have of capitalism, a fact which perhaps indicates the great unwashed are less out of synch with the critical stance artists take toward their society than Ms Paglia would have us believe.

No, what is really loony is her implied notion that denizens of the art world were ever anything but card-carrying members of a hermetically sealed sociopolitical echo chamber. Visual art is now and always has been a hand-crafted luxury good, produced by a relatively small community of artisans in tiny numbers for an equally tiny community of wealthy patrons and collectors. Fine artists have never been in touch with “the general audience,” whatever that is supposed to mean. They produce and sell art for and to the sociopolitical elite, whatever that elite happens to be at the time. In the past, the art-sponsoring elite consisted of Popes, Borgias, and wealthy Dutch merchants, among others. Today it consists of the pillars of modern financial capitalism, wealthy plutocrats and corporate institutions. This forms a particularly ironic counterpoint to Ms Paglia’s assertion that fine art is hostile to capitalism, given that the hedge fund grandees, Philip Morris corporate art buyers, and trust fund parasites contemporary artists sell to are its greatest boosters. Do you really think Steve Cohen is unaware of the political agenda of pieces in his collection? Do you really think he cares?

Let’s face it. The general population normally doesn’t give a rat’s ass about fine art. Sure, they make an annual pilgrimage to the local art museum, for some “kulcha,”—normally when out-of-town relatives visit, natch—and they visit museums and historical cultural sites when they travel abroad. But in each instance almost all of them look blankly at the artwork of any era, mumble how their child could do better and scoff at the newer ones, and can’t wait to get back to some football and pizza at the hotel. You want to know what kind of art the common man likes? Leroy Nieman prints and Thomas Kinkade paintings. The common man in Renaissance Italy was just as oblivious: he might ooh and ahh over the realism of the sword cut in Jesus’s side on the painted altarpiece, but he didn’t linger in church for aesthetic contemplation. The concept of fine art for the common man is nonsense. They have no interest in it. Why should they?

* * *

What is particularly bizzare in the end about Ms Paglia’s disquisition is her schizophrenic take on what she sees as the solution to the problem she has manufactured identified. In one breath, she says “young artists must be rescued from their sanitized middle-class backgrounds,” presumably by being taught how to woodwork, throw a pot, or scumble oil paint across a canvas, like the heroic Americans of her youth who grew up with steel mills, shoe factories, and leaded gasoline. In the next, she glorifies clear-eyed, commercially savvy Promethei bringing sleek and streamlined industrial design to the masses. Industrial design, Ms Paglia laments at the end, which lacks the spiritual dimension of great works of art.

What conclusion, if any, is she actually trying to draw?

Thus we live in a strange and contradictory culture, where the most talented college students are ideologically indoctrinated with contempt for the economic system that made their freedom, comforts and privileges possible. In the realm of arts and letters, religion is dismissed as reactionary and unhip. The spiritual language even of major abstract artists like Piet Mondrian, Jackson Pollock and Mark Rothko is ignored or suppressed.

Thus young artists have been betrayed and stunted by their elders before their careers have even begun. Is it any wonder that our fine arts have become a wasteland?

College students are the common man, Camille, in numbers if not socioeconomic status. Most of them will have little interest in or interaction with fine art of any kind over the course of their lives. Far fewer of them, plus some talented non-college graduates, will ever actually pick up a brush, chisel, or video camera. An even smaller subset of these will ever make an impact at all. Their output will be tiny, scattered, and subject to being lost, ignored, or appreciated for all the wrong reasons. Most will never be able to support themselves or their families.

If there is a tragedy about fine art, it is that it is simultaneously so small, unprotected, and unimportant on a personal scale and potentially so important on a cultural and historical one. You can’t socially engineer your way around that. It is the nature of the beast.

1 Hence the title, unexplained or even addressed in the article, “How Capitalism Can Save Art.” You may note that I do not address her point about fine art’s divorce from religion. First, I am not so sure this is true, at least when it comes to spirituality, but it is incontrovertible that religious institutions no longer sponsor fine visual art in the way they used to. Should that change, I am sure you would see a veritable resurgence of religious artwork. Artists gotta eat, too, you know.2 I hope and presume Ms Paglia realizes there are and have been non-capitalist societies in the world and that they have included at least their fair share of artists.

Tuesday, October 2, 2012

Villager:“How can we find a samurai we can pay with only rice?”Gisaku:“Find hungry samurai.”

— The Seven Samurai

The private equity industry has a problem.

And no, by a problem I do not mean the Presidential candidacy of one of its former grandees and the unwelcome proctological scrutiny which that has called down upon its normally painfully private denizens. Instead, these fiercely proud ronin are running out of time.

The private equity world is sitting on [approximately $1 trillion of uninvested capital]. It’s what the industry calls dry powder. If they don’t spend their cash pile snapping up acquisitions soon, they may have to return it to their investors.

Nearly $200 [billion] 1 from funds raised in 2007 and 2008 alone needs to be spent in the next 12 months or it must be given back.

Private equity executives, after spending the last several years largely on the sidelines amid the economic uncertainty — often proclaiming “patience” as an explanation — have begun to be anxious that they may need to go on a shopping spree.

Now a person educated in the aspirational propaganda of Atlas Shrugged and the Private Equity Growth Capital Council might wonder just what the panic is about. Surely the gimlet-eyed fiduciaries of Park Avenue, when faced with the unattractive selection of poor quality, overpriced corporate merchandise for which they blame their relative inactivity over the recent past would be cold bloodedly rational enough to simply return their investors’ capital with a smile and a shrug and a “Better luck next time, Old Bean,” no?

No, not really. Not even close.

* * *

First, to unpack this mystery one must dispense with a couple mischaracterizations Mr. Sorkin and his sources employ which cloud the issue at hand. Mischaracterizations, truth be told, which I and almost everyone else in the finance industry use as descriptive shorthand simply because it takes too much time to speak completely accurately. The biggest of these is that private equity firms actually have the hundreds of billions (or trillion) of dollars of limited partner funds they raise to invest in their sweaty little hands.

Tempting as it may be to imagine Steve Schwarzman and Leon Black dressed in top hat, tails, and duck bill masks whooping and hollering atop $10 billion mountains of gold coins in swimming pool vaults deep under Midtown Manhattan streets, private equity firms almost never get to hold the actual money nominally under their control for longer than it takes to keystroke a wire transfer into somebody else’s bank account. The multibillion dollar funds they raise with such fanfare in the press represent commitments by their limited partners to invest up to that amount in appropriate investments described and limited by the master fund agreement, not actual currency sitting in a bank account. When the financial sponsor finds and buys a company, it levies a capital call on its investors, and they are contractually obligated to deliver those funds in a timely fashion so the general partner can purchase the target. The trillion dollars which Mr. Sorkin so gleefully describes is not actual money gathering dust under the Carlyle Group’s mattress but rather a promise to invest that much by the pension funds, university endowments, and other institutional investors who employ it and its brethren to make money.

Second, there is the issue of how long financial sponsors actually get to call that money from investors, the key issue at hand but one which Mr. Sorkin skips rather lightly over in his haste to portend doom. For while most private equity firms raise investment funds with lives of a decade or more, by the same token most of them have significantly shorter actual investment periods. Usually, if the general partner is unable to find appropriate companies to buy or other investments to make within four to six years of the initial closing of the fund, the limited partners’ obligation to fund further capital calls goes away. More importantly, from the private equity firm’s perspective, the fund agreement dictates that it can no longer charge its full (2%) management fee on the full committed amount. In other words, if financial sponsor Dewey Trickem & Howe only spends $4 billion of its $10 billion DTH Rape and Pillage Fund XXIII by year six, it can no longer charge its limited partners $200 million per year in management fees. Instead, it can only dun them for 2% (or less) of the actual money invested, $4 billion, or a paltry $80 million. Given that DT&H has lots of expenses to pay, including luxurious Park Avenue office space, oodles of advisors and consultants, and legions of sharp-toothed Henry Kravis wannabes, you can just imagine how little they want to let that $6 billion of uncommitted capital (and, more importantly, $120 million of annual income) slip through their fingers.

Gross these management fees up across the multiple funds which large asset managers run in parallel (Fund I, fully invested and in harvest mode; Fund II, recently fully invested; and Fund III, recently raised and currently being invested), and you can see the 2% management fees which these firms charge add up to some serious revenue. Spread it out across multibillion dollar investment firms which employ a relatively paltry few hundred professionals, and you may understand that incentives to make investments which actually make money for limited partners get materially blurred by the incentive to gather assets.

In fact, faced with the decision to stick to its investment criteria and let lousy, overpriced opportunities pass—thereby losing associated management fee income—it becomes painfully clear that many private equity firms face very strong incentives to take a flyer. After all, the funds they are investing are, for the most part,2 not their own but rather their limited partners’. Why not invest them in second-rate, overshopped, undermanaged properties at 10 times EBITDA? Sure, the likelihood that you’ll earn a decent return is slim, but the financial sponsor’s employees hold a contractual option to 20% of the upside (the famous “carried interest”) on the off chance it does. In some respects, it is a free option, and everyone knows you shouldn’t give up free options without a fight. Sure, the investment will probably be crap, and may even go belly up, but dem’s da breaks, no? Caveat (institutional) investor.

* * *

So it is a fair and reasonable worry that the wall of soon-to-expire institutional commitments to private equity may trigger a bout of less-than-fiduciary shenanigans on the part of the finance professionals entrusted to manage them. This situation is also a timely reminder that the primary mission of any institution, once it becomes large enough, is the perpetuation and survival of the institution itself. Notwithstanding private equity’s reputation for attracting ruthless, clear-eyed homo economici, it is well to remember that incentives are not always what they seem, and often cut both ways.

It is also a salutary cheer to me and my colleagues in my industry, who are busy sharpening our skinning knives and licking our chops as the bison herd thunders toward the commitment expiration cliff. For it’s an ill wind that blows nobody any good.3

Kambei Shimada:“Go to the north. The decisive battle will be fought there.”Gorobei Katayama:“Why didn’t you build a fence there?”Kambei Shimada:“A good fort needs a gap. The enemy must be lured in. So we can attack them. If we only defend, we lose the war.”

Good. I’ve got a couple of real lemons to unload.

1 The original article published Monday evening cited $200 million as the amount requiring investment, but I have taken the liberty of correcting it, since this is clearly ludicrous. Two mid-size financial sponsors could spend $200 million in an afternoon without hardly trying, much less Blackstone or Carlyle. I wouldn’t be surprised if Steve Schwarzman spent $200 million on crab claws alone each year. An otherwise uneducated reader might also wonder what the fuss is about if only 0.02% of the trillion dollar total is expiring by year end. It seems they need to teach some remedial mathematics in journalism school.2 Now to be fair, many private equity firm professionals invest a significant amount of their own money in their funds alongside limited partners, and this can act as a powerful reinforcement to their proper fiduciary duties. But without this natural alignment of incentives from skin in the game, limited partners should be exceedingly skeptical that financial sponsor employees have their best interests fully in mind at all times.3 And it’s a big bison herd. Levered up at a typical 30% to 40% equity ratio, $1 trillion of uncommitted equity in private equity hands translates to $2.5 to $3 trillion of purchasing power. Fire up the barbie, Ralph!

Saturday, September 22, 2012

Lauren Tara LaCapra put up an interesting piece on Goldman Sachs’ declining employee compensation yesterday on Reuters. As part of it she interviewed a “prominent investor” in financial stocks who believes that Goldman is not doing enough to cut pay. He says

management is not seeing things the same way as shareholders because they have fared much better financially, even in bad times.

To illustrate this gap, he compared return-on-equity for common shareholders against compensation as portion of common equity. (For ROE, he divided pretax earnings by common shareholder equity and for the compensation measure, he adjusted pay for estimated tax costs and divided that by common shareholder equity.)

According to his calculations, Goldman employees have done better than shareholders by 10 percentage points, on average, since the firm went public in 1999. That equates to $34.7 billion over those 12 years, he said, not including what Goldman spends to repurchase shares issued to employees.

To put that figure in perspective, Goldman’s current market cap is about $57.5 billion.

But this is just bizzare, like comparing apples and carburetors.

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When it comes to discussing compensation in investment banking, people seem to forget that bankers are a factor of production for the firms which employ them. At base, banking is a pretty simple business; we gather together a bunch of other people’s money and hand it over to employees who we hope will use it to make even more money. Our raw material is money, or capital, our finished product is money, or return on capital, and our primary operating costs are the cost of that capital, the cost of the labor which turns money into more money, and various other lesser doodads we supply our employees to help them accomplish this transformation, like information technology, real estate, travel and entertainment reimbursement, and lobbyists to keep the government and regulators off our backs. Our productive assets are people, highly skilled labor who wear shoes and walk out the door every day. Investment bankers are like the robots and machinery that manufacturing companies use to transform steel and plastic and energy into, say, automobiles. Unlike General Motors’ robots and assembly lines, however—or the loans and common equity in our own industry—labor does not show up on our balance sheets. Labor is simply an operating cost, a cost of doing business.

Common equity, on the other hand, is a residual claim on the profits of a business, after you have paid your operating costs and the claims of other capital providers like lenders and bondholders which are senior to you. Return on equity is an output of your business model; employee compensation cost is an input.1 And, most importantly, the cost of labor in banking, like everywhere else, is determined at least intially independently of the cost (or required market return) of equity. If you want to run an investment bank, you have to hire and retain investment bankers, whether you are profitable or not, and you will pay the going rate in that labor market. Since we are fungible factors of production, if you cannot afford to pay us what your competitors will, we will leave and you will be unable to generate any profits at all. You might as well shut down.

Now of course the price of labor, like any factor of production, is sensitive in the intermediate and longer term to the returns on capital which employs it. If, as we may be witnessing now in finance, the long term returns to capital in an industry decline, there will be fewer capital providers who want to fund investment banks, banks will shrink, and fewer bankers will be employed. Aggregate and average individual banker compensation will decline. But this adjustment is not immediate, and the demands of inertia and wishful thinking will likely keep labor rates higher than otherwise justified for quite some time.

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Another factor comes into play, which commentators, journalists, and investors seem to have trouble remembering when contemplating compensation in my industry. Even before new risk control mechanisms like clawbacks were implemented in response to the recent financial crisis, investment banks paid a very substantial portion of banker compensation in the form of deferred pay. A generic mid-level investment banker might be paid a fixed salary of $250,000 per year and earn an average bonus of $1,000,000 in a decent year. But of that $1,000,000, perhaps as little as $250,000 might be paid in cash, with the rest coming in the form of unvested stock in the company, restricted stock units, options, and other funny money which get paid out over a period of years. A simple such scheme might have the banker getting $750,000 in restricted shares of the bank’s own common equity which vest in equal installments over the next three years. (A few particularly nasty programs use what is called “cliff vesting,” in which the deferred pay vests all at once after three to five years.) The form such pay takes is often restricted stock, with the number of shares determined by the price of the bank’s stock on the award date, when the bonus is awarded. If Bank ABC is trading at $50 per share, for example, the banker in question would have 5,000 shares vesting on each of the first, second, and third anniversary of the award date.

A little thought will show you that such a scheme is far less favorable to the banker than it appears at first blush. While the banker gets headline pay of $1,250,000, she only receives $500,000 now and must wait to collect the remaining $750,000 over the next three years. Furthermore, she is exposed to the rise or fall of the bank’s stock price: she receives 5,000 shares on each anniversary whether the stock is trading at $50, $25, or $100 per share. Also, unlike the favorable carried interest capital gains treatment her former brethren and occasional nemeses in the private equity world enjoy, she gets taxed at full ordinary income tax rates immediately upon vesting, calculated on the value of the shares at the vesting date.

From the banker’s perspective, she is being forced to advance her employer a three-year interest-free loan for 60% of her nominal compensation, with the added disadvantage that she is exposed to the potential decline of her employer’s stock price, over which she individually has almost no control, to anywhere below $50 per share up to and including zero. From the bank’s perspective, this is a great deal: they have acquired zero-cost financing for 60% of their current year labor costs with no mandatory repayment risk. It is forced equity investment, the cheapest capital you can find. And, unlike true common shareholders who can take their money and run at any time, the banker cannot sell or hedge her stock prior to vesting. Lastly, if she leaves the bank voluntarily for a competitor, most banks automatically cancel her unvested shares; she only gets paid for past years’ work if she still works for the bank. Captive, costless, non-recourse capital. The true mark of my industry’s genius.2, 3

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This also means that the published financial reports of investment banks are practically indecipherable when it comes to understanding what is happening to current compensation policy and practice. Each year, the employee compensation expense line item on banks’ income statements reflects a combination of current cash compensation and the vesting of deferred compensation from up to three to five years previous. Goldman Sachs’ reported compensation expense in 2011 included pay from 2011, 2010, 2009, and perhaps even 2008 and before. There is a terrific lag to the data, and the reported number tells you almost nothing about current pay practices. In fact, if awarded pay is in fact declining, you can be certain that reported compensation ratios significantly overstate how much of the pie is being allocated to bankers now.

All of which is to say that the headline compensation ratios, and the ubiquitous average-pay-per-employee numbers that get bandied breathlessly about in the press—usually with a healthy helping of outrage, natch—tell you little about how banks are trying to control one of their biggest operating expenses. I cannot tell you what transpires in the executive suites of the biggest banks, but I guarantee you that investment banks have made a study and a science of squeezing their employees as hard as possible over pay for decades. The stated goal is to pay everybody the smallest number that will be sufficient to keep a dissatisfied banker from throwing up her hands in disgust and walking across the street to a competitor. The science comes in when designing the form such pay will take that will be the most advantageous for the bank itself while numbing the employee with reams of complex, one-sided terms and restrictions.

In my view, it is undeniably true that most investment bankers would accept significantly lower pay if it were paid 100% in cash. I know I would.

Which is not to say I’m a cheap date, mind you.

1 This is not entirely true of investment banking, since the majority of our awarded pay depends in large measure on the current year profits we generate for the firm. But this is an ex post perspective; ex ante, to employ an investment banker, you have to budget the going rate. Read on.2 Just imagine if General Motors paid 60% of the money it owes its current vendors—robot manufacturers, power utilities, assembly line workers—with GM stock. Stock it would not have to deliver if it didn’t employ those vendors in subsequent years. The auto industry might even become profitable again.3 And lest you think I am placing excessive emphasis on the cash-conserving nature of this practice, please note that non-cash deferred compensation in the form of restricted stock units and options at Goldman Sachs alone represented $2.8, $4.0, and $2.0 billion of total reported compensation expense of $12.2, $15.4, and $16.2 billion in 2011, 2010, and 2009, respectively. Those are some pretty sweet interest-free loans to the Squid from its squidlets.